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Is a Harmful Surprise Waiting for Many Student Loan Debtors?

A new consumer advisory released recently by the Consumer Financial protection Bureau says that, for students who take out private college loans with a cosigner, they may be in for a surprise if that person either passes away suddenly or files for bankruptcy, and the surprise won’t be a nice one.

In many cases, if either the cosigner passes or files for bankruptcy, the lender could suddenly demand that the loan be paid off in full and, in some cases, actually put the loan in default even if all of the payments have been made on time throughout the loan.

This is something known as an “auto default” clause that many loan agreements have and, according to the CFPB, could result in serious financial consequences for many students who’ve taken out college loans.

Rohit Chopra, the agency’s student loan ombudsman, had this to say about the “auto default” clause. “This is something that is deep in the fine print, so it is certainly a surprise to many.” Chopra added that “Parents and grandparents want to help their children or grandchildren pay for school, and the last thing they want is for them to be made worse off because of their own financial distress or death.”

Unfortunately, if someone dies or declares bankruptcy, that default can automatically happen and it might happen without any notice our request for payment in full. Once it occurs it’s quickly reported to the major credit bureaus and, as you might imagine, can seriously damage the credit profile of the student who took out the loan, including making it much harder for them to get a job, start a business or purchase a home.

Unfortunately, because most students don’t have the credit to qualify for them, most private loans require a cosigner and, since 2007, the percentage of students getting private loans with a cosigner has risen from 67% to over 90% in 2011.

That’s a big difference from Federal student loans that, in most cases, do not require a cosigner and, even if they do, they have no auto default penalty. Unfortunately, private loans tend to have fewer protections and also higher interest rates than federal loans.

Experts advise that students, and their parents or grandparents who plan to cosign their private student loan, read the promissory note first to see if it has an auto default clause.

They advise that, if it does and a student has been making all of their loan payments on time when their co-signor passes away or declares bankruptcy, they go directly to their lender and ask that the co-signer be released.

It’s not an easy process in most cases but the fact is that many lenders do have a release option. Easy or not, it’s better than the alternatives.